America's Energy Edge

The Geopolitical Consequences of the Shale Revolution

ROBERT D. BLACKWILL is Henry A. Kissinger
Senior Fellow for U.S. Foreign Policy at the Council on Foreign
Relations. MEGHAN L. O’SULLIVAN is Jeane Kirkpatrick Professor of the
Practice of International Affairs at Harvard University’s Kennedy School
of Government. She also consults for energy firms on geopolitical risk.
Both served on the U.S. National Security Council staff in the George
W. Bush administration.

A pumpjack brings oil to the surface in the Monterey Shale, California, April 29, 2013. (Lucy Nicholson / Courtesy Reuters)

Only
five years ago, the world’s supply of oil appeared to be peaking, and
as conventional gas production declined in the United States, it seemed
that the country would become dependent on costly natural gas imports.
But in the years since, those predictions have proved spectacularly
wrong. Global energy production has begun to shift away from traditional
suppliers in Eurasia and the Middle East, as producers tap
unconventional gas and oil resources around the world, from the waters
of Australia, Brazil, Africa, and the Mediterranean to the oil sands of
Alberta. The greatest revolution, however, has taken place in the United
States, where producers have taken advantage of two newly viable
technologies to unlock resources once deemed commercially infeasible:
horizontal drilling, which allows wells to penetrate bands of shale deep
underground, and hydraulic fracturing, or fracking, which uses the
injection of high-pressure fluid to release gas and oil from rock
formations.

The resulting uptick in energy production has been dramatic. Between
2007 and 2012, U.S. shale gas production rose by over 50 percent each
year, and its share of total U.S. gas production jumped from five
percent to 39 percent. Terminals once intended to bring foreign
liquefied natural gas (LNG) to U.S. consumers are being reconfigured to
export U.S. LNG abroad. Between 2007 and 2012, fracking also generated
an 18-fold increase in U.S. production of what is known as light tight
oil, high-quality petroleum found in shale or sandstone that can be
released by fracking. This boom has succeeded in reversing the long
decline in U.S. crude oil production, which grew by 50 percent between
2008 and 2013. Thanks to these developments, the United States is now
poised to become an energy superpower. Last year, it surpassed Russia as
the world’s leading energy producer, and by next year, according to
projections by the International Energy Agency, it will overtake Saudi
Arabia as the top producer of crude oil.

Much has been written lately about the discovery of new oil and gas
deposits around the world, but other countries will not find it easy to
replicate the United States’ success. The fracking revolution required
more than just favorable geology; it also took financiers with a
tolerance for risk, a property-rights regime that let landowners claim
underground resources, a network of service providers and delivery
infrastructure, and an industry structure characterized by thousands of
entrepreneurs rather than a single national oil company. Although many
countries possess the right rock, none, with the exception of Canada,
boasts an industrial environment as favorable as that of the United
States.

The American energy revolution does not just have commercial
implications; it also has wide-reaching geopolitical consequences.
Global energy trade maps are already being redrawn as U.S. imports
continue to decline and exporters find new markets. Most West African
oil, for example, now flows to Asia rather than to the United States.
And as U.S. production continues to increase, it will put downward
pressure on global oil and gas prices, thereby diminishing the
geopolitical leverage that some energy suppliers have wielded for
decades. Most energy-producing states that lack diversified economies,
such as Russia and the Gulf monarchies, will lose out, whereas energy
consumers, such as China, India, and other Asian states, stand to gain.

If oil prices fall and stay low, every government that relies on hydrocarbon revenues will find itself under stress.

The biggest benefits, however, will accrue to the United States. Ever
since 1971, when U.S. oil production peaked, energy has been construed
as a strategic liability for the country, with its ever-growing thirst
for reasonably priced fossil fuels sometimes necessitating incongruous
alliances and complex obligations abroad. But that logic has been
upended, and the newly unlocked energy is set to boost the U.S. economy
and grant Washington newfound leverage around the world.

(Ib Ohlsson)

THE PRICE IS RIGHT

Although it is always difficult to predict the future of global
energy markets, the main effect the North American energy revolution
will have is already becoming clear: the global supply of energy will
continue to increase and diversify. Gas markets have been the first to
feel the impact. In the past, the price of gas has varied greatly across
the three largely distinct markets of North America, Europe, and Asia.
In 2012, for example, U.S. gas prices stood at $3 per million BTU,
whereas Germans paid $11 and Japanese paid $17.

But as the United States prepares to generate and export greater
quantities of LNG, those markets will become increasingly integrated.
Already, investors have sought government approval for more than 20 LNG
export projects in the United States. However many end up being built,
the exports flowing from them will add to major increases in the flow of
LNG that are already occurring elsewhere. Australia is soon set to
surpass Qatar as the largest global supplier of LNG; by 2020, the United
States and Canada together could export close to Qatar’s current LNG
capacity. Although the integration of North American, European, and
Asian gas markets will require years of infrastructure investment and
the result, even then, will not be as unified as the global oil market,
the increased liquidity should help put downward pressure on gas prices
in Europe and Asia in the decade ahead.

The most dramatic possible geopolitical consequence of the North
American energy boom is that the increase in U.S. and Canadian oil
production could disrupt the global price of oil -- which could fall by
20 percent or more. Today, the price of oil is determined largely by the
Organization of the Petroleum Exporting Countries, which regulates
production levels among its member states. When there are unexpected
production disruptions, OPEC countries (primarily Saudi Arabia) try to
stabilize prices by ramping up their production, which reduces the
global amount of spare production capacity. When spare capacity falls
below two million barrels per day, the market gets jittery, and oil
prices tend to spike upward. When the market sees spare capacity rise
above roughly six million barrels a day, prices tend to fall. For the
past five years or so, OPEC’s members have attempted to balance the need
to fill their public coffers with the need to supply enough oil to keep
the global economy humming, and they have managed to keep the price of
oil at around $90 to $110 per barrel.

As additional North American oil floods the market, OPEC’s ability to
control prices will be challenged. According to projections from the
U.S. Energy Information Administration, between 2012 and 2020, the
United States is expected to produce more than three million barrels of
new petroleum and other liquid fuels each day, mainly from light tight
oil. These new volumes, plus new supplies coming on line from Iraq and
elsewhere, could cause a glut in supply, which would push prices down --
especially as global oil demand shrinks due to improved efficiency or
slower economic growth. In that event, OPEC could have a hard time
maintaining discipline among its members, few of which are willing to
curb their oil production in the face of burgeoning social demands and
political uncertainty. Persistently lower prices would create shortfalls
in the revenues they need to fund their expenditures.

A pumpjack brings oil to the surface in the Monterey Shale, California, April 29, 2013. (Lucy Nicholson / Courtesy Reuters)

WINNERS AND LOSERS

If oil prices fall and stay low, every government in the world that
relies on hydrocarbon revenues will find itself under stress. Countries
feeling the pinch will include Indonesia and Vietnam in Asia; Kazakhstan
and Russia in Eurasia; Colombia, Mexico, and Venezuela in Latin
America; Angola and Nigeria in Africa; and Iran, Iraq, and Saudi Arabia
in the Middle East. These countries’ abilities to endure such fiscal
setbacks vary and would depend in part on how long low prices lasted.
Even with a more moderate drop in prices, the increased volume and
diversity of the oil supply would benefit energy consumers worldwide.
Countries that like to use their energy supplies for foreign policy
purposes -- usually in ways that run counter to U.S. interests -- will
see their influence shrink.

The biggest beneficiary of the North American energy boom, of course, will be the United States.

Of all the governments likely to be hit hard, Moscow has the most to
lose. Although Russia possesses large reserves of shale oil that it
could eventually develop, the global supply shift will weaken the
country in the short term. The influx of North American gas to the
market will not entirely free the rest of Europe from Russia’s
influence, since Russia will remain the continent’s largest energy
supplier. But additional suppliers will give European customers leverage
they can use to negotiate better terms with Russian producers, as they
managed to do in 2010 and 2011. Europe will gain most from the change if
it further integrates its natural gas market and builds more LNG
terminals to import gas; such moves could help it ward off crises like
those that occurred when Russia cut off gas supplies to Ukraine in 2006
and 2009. The development of Europe’s own considerable shale resources
would help even more.

A sustained drop in the price of oil, meanwhile, could
destabilize Russia’s political system. Even with the current price near
$100 per barrel, the Kremlin has scaled back its official expectations
of annual economic growth over the coming decade to around 1.8 percent
and begun to make budget cuts. If prices fall further, Russia could
exhaust its stabilization fund, which would force it to make draconian
budget reductions. Russian President Vladimir Putin’s influence could
diminish, creating new openings for his political opponents at home and
making Moscow look weak abroad.

Although the West might welcome the thought of Russia under such
strain, a weaker Russia will not necessarily mean a less challenging
Russia. Moscow is already trying to compensate for losses in Europe by
making stronger inroads into Asia and the global LNG market, and it will
have every reason to actively counter Europe’s efforts to develop its
own resources. Indeed, Russia’s state-run media, the state-owned gas
company Gazprom, and even Putin himself have warned of the environmental
dangers of fracking in Europe -- which is, as The Guardian has
put it, “an odd phenomenon in a country that usually keeps ecological
concerns at the bottom of its agenda.” To discourage European investment
in the infrastructure needed to import LNG, Russia may also
preemptively offer its European customers more favorable gas deals, as
it did for Ukraine at the end of 2013. More dramatically, should low
energy prices undermine Putin and empower more nationalist forces in the
country, Russia could seek to secure its regional influence in more
direct ways -- even through the projection of military power.

Energy producers in the Middle East, meanwhile, will lose influence,
too. As the longtime regulator of OPEC’s spare capacity and a regional
leader, Saudi Arabia merits special attention. The country is already
facing growing fiscal constraints. It responded to the Arab Spring by
boosting public spending at home and offering generous economic and
security assistance to other Sunni regimes in the region. As a result,
since 2008, the kingdom’s fiscal breakeven oil price (the level needed
to ensure its budget balances) jumped over $40 per barrel to nearly $90
in 2014, according to the International Monetary Fund. At the same time,
more pressure is coming from the country’s extremely young population,
which is demanding better education, health care, infrastructure, and
jobs. And as its enormous domestic energy demand continues to grow, the
country will begin consuming more energy than it exports by around 2020,
should current trajectories hold. Riyadh is already trying hard to
diversify its economy. But a prolonged decline in the price of oil would
test the regime’s ability to maintain the public services on which its
legitimacy rests. Other Middle Eastern countries -- including Algeria,
Bahrain, Iraq, Libya, and Yemen -- are already living beyond the limits
of their fiscal breakeven prices.

Iran, already staggering under the weight of economic sanctions and
years of economic mismanagement, could face even more severe challenges.
The country ranks fourth in the world in oil and gas production, and it
depends on its energy supplies to project regional influence. But of
all OPEC’s members, it has the highest fiscal breakeven price: over $150
per barrel. Although it is possible that lower prices might further
diminish the legitimacy of the regime and thereby pave the way for more
moderate leaders, the fate of the recent revolutions in the Middle East,
as well as Iran’s own ethnic, religious, and other cleavages, caution
against such optimism. The net implications for Mexico are less
clear. Given its declining oil production and heavy reliance on oil
revenues for its budget, the country could well suffer if the price of
oil drops. The recent push for energy reforms could allow Mexico to
increase production enough to outweigh the effects of lower global
prices. Doing so, however, would require the government to follow up on
the reform law passed in December. It would have to implement
legislation more conducive to private investment in Mexico’s energy
sector -- including its own shale resources -- and accelerate its reform
of Pemex, the state-owned oil company.

Unlike energy producers, consumers should welcome the energy
revolution. Increased North American production has already helped
buffer markets by providing much-needed additional production during
recent disruptions of exports from Libya, Nigeria, and South Sudan.
Lower energy prices will be a particular boon for China and India, which
are already major importers and which, according to the International
Energy Agency, will see their demand for oil imports grow by 40 percent
(for China) and 55 percent (for India) from 2012 to 2035. As the two
countries import more energy from the Middle East and Africa, they will
take ever-greater interest in these regions.

China also stands to benefit in another way: its relations with
Russia could improve markedly. For decades, history and ideology have
kept these two countries from finding common cause, despite the obvious
benefits that would accrue from a closer partnership between the world’s
largest energy producer and its largest consumer, which happen to share
a 2,600-mile border. But as more and more North American energy comes
on line, energy demand in the developed world remains flat, and demand
continues to increase in the developing economies of Asia, Russia will
increasingly seek to secure markets in the East. Moscow and Beijing
could well move closer together on long-stalled energy deals and
pipelines and collaborate more on energy issues in Central Asia. Once
clinched, such arrangements could form the basis for a more extensive
geopolitical relationship -- one in which China would have the upper
hand.

As for India and other Asian economies, the benefits will also go
beyond the purely economic. A surge in the quantity of gas and oil
transported through the South China Sea will provide common cause to all
countries seeking to combat piracy and other risks to the free flow of
energy shipments, giving China greater incentives to cooperate on
security matters. At the same time, U.S. allies in East Asia, such as
Japan, the Philippines, and South Korea, will have the opportunity to
increase their energy imports directly from the United States and
Canada. Their ability to rely on North American partners, shipping oil
and LNG via shorter, more direct sea routes, should also give these
countries greater peace of mind.

THE U.S. ADVANTAGE

The biggest beneficiary of the North American energy boom, of course,
will be the United States. The most immediate effect will be the
continued creation of new jobs and wealth in the energy sector. But
beyond that, since U.S. gas is among the cheapest in the world, U.S.
industries that rely primarily on gas for feedstock, such as
petrochemicals and steel, will continue to see their competitive
advantages grow. The energy boom is also providing an economic fillip by
fueling investments in U.S. infrastructure, construction, and services.
The McKinsey Global Institute estimates that by 2020, unconventional
oil and gas production could boost the United States’ annual GDP by
between two and four percent, or roughly $380–$690 billion, and create
up to 1.7 million new permanent jobs. Furthermore, since energy imports
account for roughly half of the more than $720 billion U.S. trade
deficit, declining energy imports are already leading to a more
favorable U.S. trade balance.

The spread of shale technology across the globe will be good news for the climate.

A diminished reliance on energy imports should not be confused with
full energy independence. But the U.S. energy windfall should help put
to rest declinist thinking about the United States. Moreover, the end of
U.S. dependence on overseas energy supplies -- and on the producer
countries with which Washington has often had prickly relations -- will
grant the United States a greater degree of freedom in pursuing its
grand strategy. But the United States will remain firmly linked to
globalized energy markets. Any dramatic disruption of the global oil
supply, for instance, would still affect the price at the pump in the
United States and derail growth. Washington will therefore maintain an
interest in preserving the stability of international markets. Nowhere
is that truer than in the Middle East, where vital U.S. interests -- in
preventing terrorism, countering nuclear proliferation, and promoting
regional security to protect allies such as Israel and ensure the flow
of energy -- will endure. So will the need to police the global commons,
such as the major sea-lanes through which trade in energy and other
goods flows.

These truths remain poorly understood, however. U.S. policymakers
need to start explaining to both domestic and foreign audiences that
although the energy landscape is changing, U.S. national interests are
not. Newfound oil and gas will not cause Washington to disengage from
the world. To be sure, the United States will remain, by almost any
measure, the most powerful country on the planet. Yet it will never be
able to insulate itself from shocks to the global economy, and so it
will remain deeply involved overseas. This message requires particular
emphasis in the Middle East, given Washington’s exit from Afghanistan
and Iraq and its announced pivot toward Asia.

U.S. policymakers will also need to make sure they protect the
sources of the country’s energy wealth. Even though private-sector
players have driven nearly all the advances that unleashed the boom,
their success has depended on a supportive legal and regulatory
environment. Leaders at both the state and the federal levels will have
to strike the right balance between, on the one hand, addressing
legitimate concerns over the environmental and other risks associated
with fracking and, on the other hand, securing the economic benefits of
production.

Likewise, leaders in the U.S. energy sector should work with public
authorities to establish standards of transparency, environmental
protection, and safety that can help build public confidence and address
the risks of developing shale resources. And the country as a whole
will have to update and expand its energy infrastructure to fully
harness developments in unconventional oil and gas -- a transformation
that will require substantial investments in building and modifying
pipelines, railroads, barges, and export terminals.

OIL AND GAS DIPLOMACY

In addition to bolstering the U.S. economy, the energy boom promises
to sharpen the instruments of U.S. statecraft. When it comes to levying
economic sanctions, a diversified energy supply confers distinct
advantages. It would have been nearly impossible to put in place the
unprecedented restrictions on Iran’s oil exports, for example, absent
the increase in North American supply. Unlike the sanctions against
Iran, Iraq, Libya, and Sudan in the recent past, which were imposed
during global oil gluts, the current sanctions on Iran were put in place
when the oil market was tight and prices were high. Getting the support
of other countries reluctant to impose such strict measures on Tehran
required Washington to make a credible case that removing Iranian oil
from the international market would not cause a price spike. The
sanctions that Congress passed in December 2011 conditioned the
imposition of certain strictures on the administration’s determination
that there was enough oil in the global market to ask other countries to
reduce their imports.

While this provision gave the White House an effective waiver, it
never used it, thanks to steadily increasing U.S. production of light
tight oil, which compensated for the more than one million barrels a day
of Iranian oil that the sanctions forced off the market. That U.S. oil
allowed Washington to assuage other governments’ fears of a price spike
and thereby win international support for rigid and exacting sanctions.
These measures did major damage to the Iranian economy and helped push
Tehran to the negotiating table. Absent new U.S. supplies, the sanctions
would likely never have been approved.

The energy revival is also providing U.S. trade negotiators with
newfound leverage as other countries compete for access to U.S. LNG.
Washington is currently negotiating two major multilateral trade deals:
the Transatlantic Trade and Investment Partnership (with the 28
countries of the EU) and the Trans-Pacific Partnership (with 11
countries in the Asia-Pacific and the Americas). When it comes to LNG
exports, U.S. law grants automatic approval to applications for
terminals intended to ship gas to countries that have signed free-trade
agreements with Washington. Applications for LNG terminals designed to
send gas elsewhere, by contrast, must go through a review process that
determines whether such trade is in the U.S. national interest. For the
many countries in Asia and Europe that want to add U.S. natural gas
imports to their energy mix, achieving this special trade status holds
extra value. In fact, this incentive proved crucial in convincing Japan
-- hungry for gas in the wake of the Fukushima disaster, which took its
entire nuclear power infrastructure offline -- to join the talks for the
Trans-Pacific Partnership.

The shift in global energy also gives Washington a new way of
reinforcing its alliances. Many countries now hope to follow the United
States’ lead and start tapping their own unconventional gas and oil
resources, and the U.S. government has started to integrate the
country’s energy experience into its diplomacy. Two State Department
projects -- the Unconventional Gas Technical Engagement Program and the
Energy Governance and Capacity Initiative -- are bringing technical
expertise from across the government to help other countries (so far,
small developing ones) build up their own oil and gas industries.

The government should expand on these initial efforts and link them
to its broader alliance strategy by supporting such countries as Poland
and Ukraine as they work to capitalize on their domestic shale reserves.
New production in these and other countries would not only lessen the
risk of conflict over scarce resources but also help states produce and
consume more climate-friendly energy without sacrificing the economic
growth they need. Washington should work to help them understand the
particular policies that allowed the boom to occur on U.S. soil and,
where welcome, offer advice on how to create similar environments.

The United States should also begin using its new energy resources to
prevent allies from being bullied by less friendly suppliers. As it
reviews applications for LNG export licenses and assesses their national
security implications, the Department of Energy should consider whether
the proposed projects support U.S. allies -- a move that could
encourage U.S. energy companies to export to such countries, helping
those countries resist pressure from Russia or elsewhere. The U.S.
government and its partners should also support regular forums that
bring together private-sector energy experts and investors to help other
countries develop their own shale resources. Although such expanded
public-private dialogues would not result in increased production right
away -- even in the most favorable environments, development takes years
-- they would nonetheless serve as a public symbol of American
solidarity.

In a similar vein, the U.S. government should use its own expertise
on unconventional energy to engage directly with foreign governments --
especially Beijing. The United States shares many diverse interests with
China. Both countries are massive energy consumers. Both desire a
stable and growing global economy, which depends on the reliable flow of
reasonably priced energy. Both want to minimize climate change. And
both want to diversify their energy supplies.

Such an overlap of interests between the world’s top two energy
consumers creates ample room for collaboration. In December, the United
States and China reaffirmed their shared interest in “secure and
well-supplied energy markets” and discussed cooperating to develop
China’s energy resources, including shale gas. Chinese companies are
already investing billions in shale developments at home and in the
United States. But Washington and Beijing should accelerate progress on
this front by broadening the U.S.-China Strategic and Economic Dialogue
to include light tight oil and by committing real resources to the joint
development of techniques for exporting shale oil and gas in an
efficient and environmentally responsible manner. If U.S.-Chinese
relations improve, the two sides could work together with other energy
consumers to enhance global energy security -- for example, by extending
antipiracy operations around the Horn of Africa.

Finally, the shale gas revolution can enhance U.S. leadership on
climate change. Natural gas emits up to 40 percent less carbon than
coal, and the United States is now meeting its climate goals not thanks
to bold decision-making in Washington but simply because the economics
of gas have proved so much more favorable than those of coal. The
resulting downward trend in U.S. carbon emissions has given Washington
greater credibility in climate talks than it once had; the U.S.
government should use it to assume a more forceful stance toward
countries that have resisted reining in their emissions.

The spread of shale technology across the globe will be good news for
the climate in other ways. Some environmentalists fear that the
widespread replacement of coal with gas, while reducing emissions in the
short term, will lessen the pressure for more far-reaching reforms. But
even though shifting from coal to gas would not solve the problem of
greenhouse gas emissions, it could buy enough time for the next
generation of technological and policy innovations to take hold, and
these innovations could cut emissions even more dramatically.

ENERGY AND INFLUENCE

The North American energy revolution is here, it is big, and it will
only increase in importance as the United States comes close to becoming
a net energy exporter, which is set to happen around 2020. The
resulting shift in global energy supplies will benefit consuming
countries and erode the power of traditional producers. These
developments could also undercut OPEC’s traditional role as the manager
of global energy prices, perhaps to the extent that energy prices
plummet. Such a disturbance could, in turn, cascade through all
countries that depend on hydrocarbons for their public finances. Even
without such a dramatic drop in prices, the global flow of energy will
continue to be transformed -- and, with it, economic and geopolitical
relationships.

The United States, meanwhile, will be uniquely positioned to profit
from the shift and seize new opportunities. The energy boom will add
fuel to the country’s economic revitalization, and the reduction of its
dependence on energy imports will give it some measure of greater
diplomatic freedom and influence. The energy boom will not solve all the
challenges facing U.S. policymakers: Washington still must manage the
aftermath of more than a decade of war in Afghanistan and Iraq, its own
fiscal profligacy, hyperpartisanship along the Potomac, the erosion of
trust among many allies in the wake of revelations about U.S.
surveillance, and the rise of China. That said, the huge boom in U.S.
oil and gas production, combined with the country’s other enduring
sources of military, economic, and cultural strength, should enhance
U.S. global leadership in the years to come -- but only if Washington
protects the sources of this newfound strength at home and takes
advantage of new opportunities to protect its enduring interests abroad.

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